2018-06-10 10am EDT  |  #inflation #TIPS #bonds

I have been banging on the inflation drum for so long I feel that even Todd Rundgren would be sick of hearing from me. While a couple of years ago, the majority of pundits were not talking about inflation - most were focused on the Fed’s inability to create rising prices in anything except financial assets - recently the market has awoken to the risks that accompany a decade of bat-shit-crazy central bank monetary policies.

With the current popularization of warnings about the coming inflation, I don’t know if I can add any value rehashing the points filling financial airwaves. The market seems to have finally caught on. Inflation is coming. In fact, it’s already here. And it will get a lot worse.

Instead of writing yet another piece reiterating my beliefs about why inflation will be a problem in the coming decades, I have decided to explore how market inflation expectations have changed over the past couple of years.

At the start of 2016, the market was pricing in a 1% 5-year breakeven inflation rate. That meant inflation had to average less than 1% for the next five years for nominal bonds to outperform TIPS (Treasury Inflation Protected Securities). Stop and think about that for a moment. The Federal Reserve has an inflation target of 2%. Yet the market did not believe they could achieve an inflation rate of even half their target.

The three Ds (deflation, demographics, and debt) were on everyone’s lips. It made little sense to invest in inflation-protected securities when everyone knew there could be no inflation.

Well, guess what? That 1% 5-year breakeven rate has now risen to 2%.

Today the market is expecting the Federal Reserve to hit its 2% inflation target.

But the most interesting part of this higher repricing of inflation expectations? Instead of worrying about inflation getting away from the Fed, the market is more worried about a short-term spike in inflation than a sustained long-term rise.

To illustrate this, let’s look at the US 2-year and 30-year breakeven inflation rates.

The 2-year breakeven inflation rate has risen from 0% in September 2015 to almost 2% today. During this same period, the 30-year breakeven inflation rate has stayed steady at approximately 2%, finishing that same period about an eighth of a percent higher.

The vast majority of the inflation expectation rise has been centered at the front end of the curve!

Here is another way to think about it. Instead of looking at breakeven inflation rates, let’s look at the yield curve of TIPS securities. This is “real yield” - the rate which an investor will earn after inflation.

Look at the curve two years ago - it was steep with an investor “earning” almost 100 negative basis points at the 1-year term and 75 basis points at the 30-year term. That was a spread of 175 basis points. Contrast that to today when the front end is roughly the same as the long end. Not only that, but the curve is actually inverted at the front end.

What does this mean?

Although investors have priced in increased inflation expectations, there are few concerns about long-term inflation rising in a meaningful way. The market has acknowledged that the economy is about to experience a short-to-medium-term uptick in inflation, but so far, has almost no worry that inflation will get away from the Federal Reserve over the long run.

Well, bought from them. I love the idea of owning long-term breakeven inflation rates. The market is still not convinced that inflation is the real worry. Although market participants grudgingly accept that inflation is headed higher, they have yet to acknowledge the potential of this becoming a serious problem. They still think the Fed has got this under control.

This is my prediction: before this is all through, investors will overpay for the longest, most leveraged inflation protection they can buy. There will be 3-times inflation ETFs created that attract hundreds of millions of dollars of assets. At that point, we will think about selling. Until then, be thankful for their skepticism.

Thanks for reading,
Kevin Muir
the MacroTourist

PS: I have been busy researching the difference between US and Canadian banks. Some of the findings have been eye-opening for me. Please watch for the post at our East West research feed. If you would like to sign up to receive the pieces directly via email, please sign up here.

Don’t look now, but for those desperate to sell Canadian banks, there might be a spread trade that makes more sense, and finally has some tailwinds at the back of both sides of the trade.